How Sustainability Can Be Incorporated Into Executive Compensation

President of Ceres, Mindy S. Lubber, says in a Harvard Business Review opinion piece that global problems like climate change “demand new business models.” Lubber warns that not creating new models will result in more than “another financial-sector meltdown,” but environmental and social problems “on a scale never before seen.” She thinks that bringing pay “into the equation” is a quick way of grabbing attention.

Several reports agree with Lubber. A Ceres report, The 21st Century Corporation: The Ceres Roadmap for Sustainability, says, “Sustainability performance results must be a core component of the evaluation of senior executive performance and compensation packages.” A report by Pascual Berrone of IESE Business School, and Luis Gomez-Mejia of Arizona State University, published last year in the Academy of Management Journal says firms need “incentive mechanisms to dissuade managers from avoidance.”

How does a company change its executive compensation scheme to incorporate sustainability? The Berrone/Mejia study lays out three factors that should be considered when designing new compensation schemes:

“Informativeness,” or the extent to which the performance measure actually reflects the agent’s contribution to the principal’s welfare.

“Risk bearing,” or the extent to which an agent may incur potential losses in pursuit of performance targets (such as lower reputation or high employment risk).

“Controllability,” or the extent to which an agent can exert some influence over a performance criterion.

British utility company National Grid announced last year it would partly base executive compensation on meeting targets for reducing carbon emissions. Joe Kwasnik, group head of climate change for the company, explains key points to Environmental Leader on how the company is implements its scheme.

Recognize that change is coming, and get ahead of the curve. National Grid decided to “weave” into its internal budgets and operations, the fact that many governments are setting targets to reduce greenhouse gases (GHG) 80 percent by 2050.

Establish a baseline and internal metrics. National Grid first set a baseline measurement of its carbon footprint.

Create a culture that rewards carbon reduction. National Grid had already reduced its GHG emissions by 30 percent since 1990.

Be ready to adjust to new policies, regulations and market information. National Grid is ready to incorporate the cost of carbon in the U.S. into its decision making when a cap and trade program is in place.

The Boston Consulting Group issued a report last year titled, Fixing What’s Wrong With Executive Compensation. Although the report does not specifically mention incorporating sustainability into executive compensation, it lists five principles for creating effective incentive compensation.

Emphasize the long term: Investors want executives to focus on long-term sustainability.

Reward relative performance: Equity based incentive compensation should reward executives when the company outperforms its peers, not just when it enjoys a windfall in the stock market.

Measure performance that executives can directly influence: Executives at the business level should be evaluated according to financial and operational performance metrics that are relevant to the units they head.

Focus on value creation: Hold executives accountable for the for the size and sustainability of the cash flows they generate after reinvestment and for the capital bets they make.

Minimize asymmetries of risk: For executives to truly act like owners, they need to experience the same risk that normal investors do.

Tom King, president of National Grid U.S., says, “Sustainability is part of our everyday discussions at National Grid.” Employees are “increasingly incentivized to put sustainability at the heart of the way we do business.” As Kwasnik said to Environmental Leader, National Grid had already reduced its emissions. Sustainability was part of the company before it changed its executive compensation scheme.

Gina-Marie is a freelance writer and journalist armed with a degree in journalism, and a passion for social justice, including the environment and sustainability. She writes for various websites, and has made the 75+ Environmentalists to Follow list by Mashable.com.